Real Rates and Gold
9

Back in the young days of this
gold bull, early 2001, gold languished in the $260s following
a multi-decade bear. With little encouraging price behavior at
that time, early contrarians focused on supply-and-demand fundamentals
to undergird their highly controversial bullish views on gold.
One key bullish thesis from those dark early days regarded gold's
behavior relative to real interest rates.

Real interest rates are the
actual returns realized by debt investors after inflation is
subtracted out. So if an investor buys a US Treasury Bill that
pays 4% a year, and inflation is running 3% a year, then he is
earning a real rate of return of 1% on his investment. His purchasing
power, the goods and services his capital can actually buy in
the real world, grows by just 1% annually.

Obviously the higher the real
rates of return available in the debt markets, the greater the
incentive for savers to divert their surplus capital into debt
investments (bonds) rather than equity investments (stocks).
Bonds are generally vastly less risky than stocks so they become
highly attractive to elite investors in high real-rate environments.

But this relationship works
the other way too. When real rates of return become too low or
even fall negative, savers' incentives to invest in bonds evaporates.
If the real purchasing power of your savings isn't growing, then
it is time to find an alternative investment where it will grow.
With general stocks in a bear market in the early 2000s, contrarians
figured that low real rates would drive investors into gold.

And we were proven right of
course! Back when I wrote my first
essay in this series, July 2001, real rates of return in
the US were very low but had not yet gone negative. Gold was
trading in the $260s and hadn't even approached $300 yet for
the first time in its young bull. But the low and falling real
rates of return were stinging bond investors and starting to
spark interest in alternative investments like gold.

Between mid-2001 and spring
2005, real rates of return generally stayed negative in the States.
Gold powered higher in its biggest bull run in decades, running
up over 75% from $255 to $455. I last looked at real rates and
gold in an
essay in March 2005. By that time they were going positive
again but the gold bull had taken on a life of its own and no
longer needed low real rates to drive investment in it.

Then just last week an old
friend wrote me about real rates and I was intrigued. I haven't
thought much about this thread of research for years now. So
I decided to break out my dusty old spreadsheets, get some new
data, and see what's been happening in this fascinating realm.
Given the countless discussions about the Fed and rate cuts lately,
it is certainly an excellent time to again consider real rates.

Real rates are the nominal
interest rates quoted in the markets less the rate of inflation
over the same period of time. Since everyone thinks of interest
rates in annual terms, it is best to use simple annual metrics
to compute real rates. One-year interest rates are logical and
easy to understand, they don't have to be annualized. Comparing
a 30-year bond yield to an annualized 1-month change in inflation
is an apples-to-oranges type of error.

The ideal nominal interest
rate to use is the yield on 1-year US Treasury Bills. Sovereign
US debt is considered the most risk-free debt in the investment
world. Since the Fed can create US dollars out of thin air at
will, nothing short of revolution or invasion will stop the US
Treasury from repaying its obligations. While 1y T-Bills aren't
widely traded today, the Fed maintains a constant-maturity data
series of 1y T-Bill yields which is perfect for real-rate calculations.

On the inflation side of this
calculation, the most widely accepted inflation gauge is the
Consumer Price Index. Since we are using one-year nominal interest
rates, we need to use the annual change in the CPI as our inflation
gauge. So real rates of return in the US are defined by the constant-maturity
yield on 1y T-Bills minus the year-over-year change in the CPI.
Nominal rates minus inflation equals real rates.

Now before you pick up the
rotten tomatoes, realize I loathe the CPI. It is a joke. It is
heavily hedonized, manipulated, and lowballed for political reasons.
Real inflation rates, which are technically the growth rates
in the US money supplies, far exceed the sanitized CPI releases.
Yet I use the CPI anyway because it is widely accepted by mainstreamers.
Using the CPI rather than true monetary growth rates understates
the case here and makes it more easily palatable by investors
who haven't yet studied
inflation in depth.

These charts show the 1y T-Bill
yield in black and the year-over-year CPI change in white. Subtracting
the latter from the former results in the blue line showing the
historical annual real rates of return in the US. Gold, in red,
is superimposed over this interest-rate and inflation data. In
this initial long-term chart, the real
gold price is also used. Nominal gold is adjusted by the
CPI to render the metal in today's dollars for superior comparability
across decades. There are many interesting things to ponder here
in order to establish a crucial historical perspective.

First, in recent history note
that real rates in the US first approached zero in 2001. I don't
think it is coincidental at all that this gold bull launched
off a multi-decade secular low around the same time. Low or negative
real rates mean bond investors either can't grow their capital
or actually lose purchasing power due to inflation even after
their investments. Such a capital-hostile environment leads savers
to seek alternative investments including gold.

But since the next chart zooms
into the modern period since 2000, we should focus on the long-term
aspects of this first chart to establish perspective. For example,
note that the black 1y T-Bill yield line declined on balance
from the late 1970s to the early 2000s. Although few investors
know it today, interest rates move in great cycles just like
the stock
markets. Nominal interest rates can't go much lower than
1%, so odds are we've seen the secular bottom and interest rates
will rise for a decade or more to come.

This has huge implications
for debtors. With interest rates highly likely to be in the up-cycle
of their long wave now, they should continue to rise on balance.
Debtors ought to realize this and insist on fixed rates for their
borrowing. As a student of the markets, I was really flabbergasted
in 2003 when mortgage brokers and debtors alike were pretending
that 1% nominal rates of return, half-century lows, were normal
and sustainable. When anything is at a half-century low, including
the price of money, odds are very high it will rise for some
time to come. The markets abhor extremes.

The white annual CPI inflation
line has also been gradually grinding lower on balance since
the early 1980s. Even with the heavy political manipulating of
the CPI, I suspect that it too has started to travel higher on
balance. Since 1983, after the big dislocations of the early
1980s, the CPI has averaged an annual growth rate of 3.1%. Anything
much below that, including this past year, is likely an unsustainable
anomaly. As is apparent above, sub-2% CPI episodes are pretty
rare in modern history.

The blue real-rate line was
last heavily negative in the 1970s. While both nominal rates
of return and inflation were high, nominal rates still couldn't
keep pace with the spiraling inflation as the Fed promiscuously
ramped the US money supplies. Note that gold soared in the 1970s.
When real rates of return head to zero or lower, owning bonds
is a losing proposition that erodes the capital of savers. Rather
than subsidize wanton debtors, savers redeploy their capital
elsewhere including into gold.

The nearly decade-long negative-real-rates
episode in the 1970s is important to ponder. Note that rates
initially went negative for a short time and recovered, kind
of like today. But inflationary cycles take far more time to
unfold so real rates eventually went negative again and helped
propel the monster gold bull of that decade. Negative-real-rates
episodes in history tend to last for many years on balance, not
just short periods of time.

After the 1970s, real rates
stayed pretty healthy until the early 1990s. It is interesting
that as real rates again approached zero in 1993, gold caught
a bid. But soon nominal T-Bill yields shot higher again, pushing
real rates way up, and the wind quickly fled from the sails of
the young gold rally. Gold then continued declining on balance
into the late 1990s as real rates remained healthy.

So interest rates are cyclical
and are likely now in a new long-term bull cycle. Inflation tends
to rise with, and even outpace, the growth in nominal interest
rates in these up cycles. Gold and alternative investments thrive
during these times when negative real rates punish rather than
reward bond investors for their act of loaning capital. It is
no coincidence that the last long low-to-negative real-rate episode
was in the 1970s when gold rocketed higher. And today's low-real-rate
episode hasn't proved much different yet.

Here is a closer look at the
first negative real-rate environment seen since the 1970s, a
rare and very important event. Real rates were negative for all
of 2003 and 2004 and some of 2002 and 2005. And indeed, despite
rising nominal yields on debt, gold commenced its first secular
bull market since the 1970s. Poor real returns in the debt markets
drive big interest in investing in gold.

The unnatural nominal interest-rate
lows of 2002 to 2004 really stand out sharply in this chart.
While even the lowballed CPI inflation was running near 2%, 1y
T-Bills were yielding just over 1%. So anyone who invested in
short-term Treasuries and other debt lost purchasing power for
their investment! They actually emerged poorer after investing
than before it. Investors won't tolerate this for long and they
fled, some into gold and commodities.

Then in 2004 nominal yields
started trending higher again but the CPI followed right along
so real rates stayed low or negative until mid-2006. Then, while
nominal market-generated yields remained flat at a much more
reasonable 5%, the annual change in the CPI plummeted. This is
highly suspicious based on the index's own history. Odds are
the perpetual methodology changes made by the CPI custodians
to appease their political masters led to this sudden fall, not
slowing underlying inflation in America.

Based on this sudden CPI change,
real rates shot up above 3% last year, but they have since fallen
to just above 2% as the YoY CPI change continues to rise back
up to more normal levels. As a lifelong saver and investor myself,
I think even 2% real is totally unacceptable. In the 1980s real
rates averaged 4.2%. This is much more reasonable. A saver should
be able to earn a fair real return on the fruits of his hard
labors, and 2% a year really isn't fair. So savers responded
in recent years by buying gold, the ultimate asset to own during
inflationary times.

If you look at today on the
far right of this chart, the recent sharp decline in 1y T-Bill
yields is readily apparent. Due to all the mortgage and credit-market
problems right now, capital has been fleeing risky mortgage-related
debt and buying high-quality debt including US Treasuries. This
huge surge in capital seeking Treasuries has driven down the
yields the markets demand that the US Treasury pay for borrowing
money. With demand for US government debt soaring, Treasury prices
rise forcing the prevailing yields to fall. Simple supply and
demand here.

While the nominal rates are
falling fast, CPI data lags a month. So this chart reflects the
latest available CPI data which isn't yet current to the end
of August like the real-time T-Bill-yield data. So far this year,
the monthly CPI releases have shown average year-over-year changes
of 2.5%. So I think 2.5% is a conservative estimate for the upcoming
August CPI data. With nominal rates near 4.0% and the CPI likely
to come in at 2.5%, all of a sudden real rates are back down
to 1.5% even based on the lowballed CPI.

Under 1.5% real, debt investors
get antsy fast. Back in early 2001 when real rates first fell
under 1.5% was when gold bottomed and started clawing higher.
From the time when real rates fell under 1.5% to the time they
went back over 1.5% in 2006, gold powered 181% higher. Although
many other fundamental
factors besides real interest rates fueled this young bull,
the low real rates certainly helped beleaguered debt investors
get interested in gold. With real rates once again on the verge
of falling under 1.5% for only the second time since 2000, gold
is very likely starting its next multi-year run higher.

Now unfortunately we can't
discuss interest rates without discussing the Fed. Unlike the
sycophantic Fed worshippers on Wall Street, I never mince words
on the Federal Reserve. The Fed is an abomination, an engine
of devastating fiat-paper inflation born unconstitutionally nearly
a century ago. The inflation unleashed by the Fed has done more
damage to Americans and the world than any other economic factor.
Endless inflation destroys incentives to work and save while
gradually eroding the moral fabric of a nation.

The Fed creates paper money
out of thin air every day. These new dollars, mostly electronic
but also some physical, immediately enter the real economy and
start to compete with existing dollars to bid on scarce goods
and services. With relatively more money bidding on relatively
fewer goods and services, prices for these goods and services
rise. A dollar you save today will purchase less and less in
the future thanks to the Federal Reserve perpetually ramping
the US money supplies.

The Fed also attempts to set
the price of money, interest rates. The very act of attempting
to set any price in secret by committee is inherently radically
anti-free-market. The Fed decreeing the benchmark US interest
rates is no different or less ridiculous than the Communist Politburo
of last century's Russia attempting to set the price of shoes
or milk. Flawed dictatorial pricing decisions made by humans
always lead to horrible inefficiencies since they impede natural
free-market pricing signals to producers and consumers.

Thus it is sadly entertaining
to watch Wall Streeters praise the Fed endlessly on CNBC and
Bloomberg. We have a horrible institution centrally-planning
our money supplies and interest rates in a perfectly Communist
command-and-control form. Rather than denounce it as an abomination
that should be slaughtered, Wall Street acts as if central planning
is totally rational and normal. What a bunch of hypocrites! Any
self-proclaimed free-market capitalist who wants the Fed to exist
is a fraud.

Anyway, it now being clear
that I wouldn't spit on the Fed if it was burning to death, this
institution is in a very dangerous place today. While the Fed
likes to believe it sets interest rates, in reality it usually
closely follows what is already happening in the short-term debt
markets. When market forces drive short-term Treasury yields
lower on their own accord, the Fed is generally forced to follow
by lowering its own rates.

The Fed can only directly set
the rate banks charge each other to borrow overnight (federal
funds rate) and the rate it charges banks to borrow directly
from it (discount rate). Beyond these overnight rates, free-market
forces dwarf the Fed's attempted manipulations. So the Fed sees
this chart, sees Treasury rates collapsing due to the flight
to quality, and it has little choice but to cut rates or risk
capital imbalances spiraling out of control.

On top of the debt markets
virtually forcing the Fed to play catch-up by cutting rates,
the US stock markets have rate cuts already priced in. Since
everyone on Wall Street expects the Fed to cut rates, if it doesn't
there will likely be a sizeable selloff or even a mini-panic.
The Fed doesn't want to be seen as ignoring the stock markets,
so it really needs to cut rates to live up to this ubiquitous
Wall Street expectation today.

But while falling Treasury
yields and Wall Street demands are forcing the Fed's hand, the
US dollar is in a very precarious place technically. The US Dollar
Index is on the verge of falling to new
all-time lows. Any rate cut will weaken the dollar as international
investors move their capital elsewhere to other first-world countries
with higher yields. So does the Fed try to preserve the dollar's
stability, one of its key mandates, or does it cut to follow
the debt markets and then watch the dollar potentially fall off
a cliff?

Always a slave to the debt
markets and Wall Street expectations, I expect the Fed will cave
in and cut rates. Wall Street will love it, but this news is
already baked in so the rally will likely be modest. International
debt investors will see the Fed as panicking and they will continue
their mass exodus out of the dollar, driving it to its lowest
levels ever. New dollar lows will beget even more selling and
gold will be a prime beneficiary.

And back to our discussion
at hand, the Fed lowering rates will reinforce bond-market perceptions
of hostile Fed intent to savers and lead to lower yields on short-term
US Treasuries. Thus any Fed cutting action, just as in the early
2000s, will drive real rates lower and eventually negative. So
it looks like we are now on the verge of another very low or
negative real-rate episode in the US. Of course this will be
very bullish for gold.

On the Fed, I almost fell out
of my chair Tuesday morning. CNBC had a headline "Should
Fed Be Abolished?" running across the bottom of its screen!
I unmuted the TV and was amazed to see an interview with four
people discussing this very question. Of course 3 of the 4 were
closet Communists and pro-Fed, but there was a lone free-market
guy there. In 2000 when Greenspan was worshipped as a demigod,
even such talk on CNBC would have been unthinkable. So maybe
we are finally moving in the right direction in popular discourse.

With real rates falling to
low levels and probably heading negative again, gold should thrive
in the months and years ahead. Low real rates are but one of
many very bullish factors for the yellow metal. If you want to
ride this ongoing secular gold bull that low real rates will
continue to help drive, the best leverage available is obtainable
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The bottom line is prevailing
US rates of return after inflation are low today and will probably
go negative again soon. During such episodes in history, gold
tends to really thrive. Debt investors, tired of trivial gains
or actual losses of purchasing power in return for lending their
capital, join in the gold rush to preserve their capital through
financial-market conditions openly hostile to savers.

The Fed, which shouldn't even
exist, is in a tough position today. It has to cut rates to follow
the debt markets' lead and appease the stock markets. But a rate
cut will likely push the dollar over the edge to new all-time
lows which will drive even more capital into gold. So while the
Fed now faces a lose-lose situation, gold faces a win-win situation
today.

Adam Hamilton, CPA

September 7, 2007

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!